James Carville reminded George Bush in 1992, the voters only care about the economy. Ultimately, the same message is required for finance researchers and “value” managers. For the past decade “Value” investors have gnashed their teeth, lit up Twitter, and continued looking for the magic bullet to make value investing relevant again. Given the assets accumulated by leading “value” firms, it is imperative for them to keep the book to price franchise relevant. For example, recently some firms and researchers argue it is important to add back expensed R&D to book value to better reflect a firm’s value. Of course, with the benefit of looking back at 10 years of book to price missing investment opportunities such as: Nvidia, Facebook, and MasterCard among others, any adjustment that increases the book to price ratio of such companies starts to make sense. While backward looking model adjustments may result in statistically significant findings, it is a sloppy intellectual practice. Is the research motivated to improve future returns, or support the insatiable hunger of marketing? The problem with such financial research is the models are calibrated knowing the answers. As Mike Tyson says, “Everyone has a plan until they get punched in the face”. Such is the case relying on results of models derived “in the sample period”. What happens to the model when it encounters a new economic environment – for example, a technology-led productivity boom or a monetary-led recovery? Until a strategy supported by a well thought out theory has decades of actual performance through numerous economic conditions, no one knows if such a strategy is robust or durable enough to handle the proverbial economic punch to the face. Absent real-time documentation with a long, out of sample period to demonstrate durability, historical financial findings are nothing more than interesting observations. The Fama French “value” factor is a great example of successful marketing, but it has failed to live up to its promise since its release. In fact, as discussed in the paper referenced below, on a pure basis, it results in portfolios with negative risk-adjusted returns.
While we admire such marketing chutzpah, we must ask: Aside from defending company franchises, why expend so much energy to save book to price, rather than directly measuring intrinsic value. After all, book to price does not even measure value, it only measures how cheap a company is relative to its book value. Cheap does not imply value. Ultimately, as Warren Buffet says – “Price is what you pay, value is what you get”. In that regard, when considering an investment strategy, it is wise to heed Carville – It’s Valuation, Stupid.
Applied Finance addresses this valuation versus cheapness issue, by clearly answering whether book to price is a causal factor that explains future stock returns, or if it “works” because of correlation. The short answer is correlation, not causality. Book to price, after controlling for intrinsic value, offers zero to negative alpha for portfolio construction.
For a much more detailed discussion that also provides a valuation-based alternative to the current book to price asset pricing regime, read our recently released research paper:
We believe this study significantly advances the existing knowledge base of understanding how markets set prices. However, we also believe it is important to understand the motives and point of view behind any research finding. In full disclosure, we began this research over a year ago with a commercial interest, and a particular point of view that happens to make enormous sense to us – understanding valuation is critical to understanding market prices. Dan Obrycki and I developed Applied Finance’s Economic Margin® and Economic Margin Valuation™ models in 1995 and began fully implementing them in 1998. Since 1998, we have performed over 20,000,000 real time, out of sample corporate valuations globally. The performance of our models has strengthened our belief that it is critical to understand valuation to construct superior portfolios. To our knowledge, no other firm has a database of intrinsic value, spanning so many years and countries, derived from a consistently applied framework to measure: corporate performance (Economic Margin®), company specific Economic Profit Horizons™, corporate risk, and capital growth to forecast economic profits. Since 1998, our Economic Margin Valuation™ models have handled numerous “economic punches to the face” and the portfolios derived from our framework have thrived relative to “value” and “growth” alternatives. The chart below depicts the performance of our Valuation Stewardship™ Large Cap strategy, versus the Russell 1000, the Russell 1000 Value, and the Russell 1000 Growth Indices. Valuation is a unique edge Applied Finance brings to the table for our clients. This data is not available through a simple Yahoo! Finance screen, as is the case for Book to Price. While we certainly do not feel the valuation investing sandbox only belongs to us, we believe that alternative valuation frameworks prove their worth through live, out of sample results. Anything less is not only intellectually dishonest but moves away from what should be the standard for serious research – real data, leading to real results.
One of many insights from our asset pricing study, is the interaction of properly understanding asset growth, economic profitability, and management actions. We created an index to track how the interaction of these factors perform relative to common broad-based passive investment alternatives, or more focused “value” and “growth” alternatives. Here is the performance of what we named the Valuation Stewardship Large Cap Index, that explicitly incorporates the interaction of economic profit, growth, and corporate actions to determine a company’s investment attractiveness.
We will expand on numerous insights from this study in the months ahead as its findings have varied and promising implications for investing. A few examples we will explore –
1. The current accepted thoughts in factor investing is that corporate capital growth destroys market value, derived from a Fama French dividend discount model representation of firm value to motivate their 5-factor model in 2015. We disagree. Investing at rates of return above the cost of capital leads to wealth creation. Arguing to the contrary is silly. Our research directly confirms that wealth creating growth leads to higher subsequent returns.
2. The movement towards passive has been a False Bargain for investors. Assuming all investors underperform passive benchmarks is a convenient marketing construct for firms with too much capital to deploy that at best will deliver market returns on those capital pools.
3. The importance of a proprietary approach is to create durable alpha. It makes no sense to believe a widely available variable such as Book to Price will have its efficacy diluted as every quant in the world runs and implements book to price screens and subtle variants.
There is much to unpack in this study, and we look forward to sharing those investment insights in the months ahead.
May Halloween bring you alpha treats.
Rafael Resendes
Co-Founder, Applied Finance
Analyst Interview – Dhaval Sanghavi CFA, CPA
Senior Fundamental Analyst in charge of the Technology sector, Dhaval Sanghavi discusses his thoughts on the overall market, the Technology sector and the Valuation 50 portfolio including some insight into a recent trade decision.
Book/Price – A Broken Factor
In today’s service economy, an economic measure of total invested capital, including intangibles from R&D and inflation adj. capital, would better capture the residual equity of common shareholders. Book equity from GAAP measures ignore these adjustments.
AFG Quantitative Review – Q3 2020
Our Q3 Quantitative Review includes an array of market insights to help understand what is driving the market and how to explain it to others. Topics include Top 5 Market Cap Companies, comparisons of high yield vs. no yield, and “Low Risk” & “High Risk” stocks as well as a Covid-19 consumer update.
Economic Margin Valuation™ – 25 Years Later
Celebrating Applied Finance’s 25th Anniversary, we highlight some of our most impactful research such as our work developing our Economic Margin Valuation Framework, the flaw in the Gordon Growth model that led to our work on Economic Profit Horizons™ as well as an introduction to our latest asset pricing study.
Small Cap Growth: Most Expensive Valuation Since Tech Bubble
The 2020 Covid-19 crisis has caused a spectacular shift in relative Valuations in the value/growth categories within the small-cap Russell 2000. In fact, this is the largest spike in relative Valuation that we’ve seen since the Tech Bubble.
Time to Reconsider Large Cap Value & Growth Allocations
In the current market, we see a difference in Valuation between value and growth names. Value stocks appear to be around their long-term normal range from a relative attractiveness standpoint. Growth companies however, appear to have become overvalued.
Understanding Recent Option Activity
Recent reports attribute the recent explosion in option activity to SoftBank and the new commission free platform, Robinhood… We take a closer look at this trend.
Market In Pictures – September 2020
For September 2020, we have put together some visual highlights of the state of markets over the past month, energy stocks, European banks getting crushed, insights on value investing and a humorous look at analyst estimates.